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June 1, 2012

Cover Story: In the Footsteps

Foreign Exchange Borrows Trading Technology Advances from Equities

By Michael Scotti

Nothing grabs attention like a good scandal. That's the story right now in the currency trading business, as two custodial banks fight claims that they "picked off" their pension fund clients with poor executions on their foreign exchange trades. The news of pending lawsuits, filed by some of the nation's largest pensions, has put every institutional money manager on alert, and scrutiny of execution quality in FX has never been higher.

Both State Street and BNY Mellon have defended their FX trading practices and said they've done nothing wrong. But as the saying goes in politics and business, "Never let a good crisis go to waste." During a two-week stretch beginning in late April, three separate vendors announced the rollout of equities-style transaction-cost measurement products for FX.

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The move to measure FX trading costs by ITG, Abel/Noser and TradingScreen is part of an expansion in the availability of equities-like trading tools and technologies in the FX market over the last decade.

Technological developments in FX trading, in some ways, look like a sequel to what happened first in equities: the rise of ECNs, algorithmic trading, smart order routing and internalized crosses. FX has an element of high-frequency trading, too.

The foreign exchange market is pegged at $4 trillion per day, with spot trading and FX swaps dominating, according to the Bank for International Settlements. Corporate treasurers account for the bulk of all trades, but money managers are a significant customer base, rising along with the expansion of overseas investing in recent years.

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Trading by telephone, once the norm, is falling by the wayside, and today, 61 percent of all trading in foreign exchange is done electronically, according to Greenwich Associates. That's up from 57 percent the previous year.

To some extent, the recent ramp-up in self-trading has been driven by the big brokers that pioneered electronic trading in equities. Today they offer algorithmic trading tools for FX. In 2006, for instance, the brain trust of Credit Suisse's electronic trading group, AES, concluded that the market structure in FX looked very much like the equities market did before the onslaught of electronic trading there, said Paul Buckley, a director at Credit Suisse's AES FX. First, there were multiple liquidity sources, like ECNs and single bank feeds. That, combined with clients' appetite for electronic trading and the growing importance of transaction-cost analysis, meant that the time looked ripe to introduce FX algorithms.

"We started to spread the word that clients could use these tools to take their destiny into their own hands and take control and work that order, or use these technologies to transfer risk instantly, so you have a full range of options," Buckley said. "It really resonated with the buyside. They said, 'Wow, I can work my own orders. I'm comfortable taking short-duration risk. I think I can improve the outcome for my investors.'"